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Sunday, February 5, 2012

On the purpose of financing

One of the key questions which a bank credit officer recommending a loan for approval by his credit committee must address is: what is the purpose of financing?

It seems that EU-elites don't ponder this question when they discuss new financing for Greece. If they did, they might come to different conclusions from what they are actually doing. What has been the purpose of new financing for Greece in the last 2 years?

One has to differentiate between financing by the EU/IMF for the Greek state and financing by the ECB for the Greek banking sector.

EU/IMF-financing for the Greek state: the principal purpose has been to finance the payment of principal and interest on sovereign debt. The remainder of the financing (estimated to be not much more than 20%) went to finance the budget deficit.

Suppose you were the sole EU/IMF decision-maker; how would you negotiate with the Greek government? Here is how I would talk to a borrower in language which one would probably not use with a government:

“Ok, we’ll finance your budget deficit up to the 3% Maastricht limit with no strings attached. If you need more than that, we need to attach some strings. We are not going to ask you to reduce your overall expenditures in a recession like this but you have to dramatically restructure your expenditures. You are wasting money on one hand and not spending enough on the other. Let me just say: stop paying pensions to the dead so that you don’t have to take money from the living! There is one thing, though. We are not going to lend you money forever which money should actually come from your tax payers. So you have to submit us plans what you are going to do about tax collection. As regards your debt service, by financing the budget deficit we are already financing the interest expense. As regards the principal payments, we are not going to finance those. Those you will have to reschedule with your creditors. We’ll be happy to help if you need our help but you have to handle this directly with your creditors”.

ECB-financing for the Greek banking sector: the principal purpose has been to finance the deficit in the current account (revenues from exports and foreign services minus imports) and to replace short-term funding cancelled by foreign banks as well a deposit-withdrawals.

Suppose you were the sole ECB decision-maker; how would you negotiate with the Greek government? Here is how I would talk to a borrower in language which Central Bankers wouldn’t use:

“Let’s see. In 2011 alone, you have lost about 57 BN EUR of liquidity which we had to replace with our loans. Specifically, you lost 21 BN EUR liquidity through the current account deficit and 36 BN EUR through deposit withdrawals. Let me say upfront: we are not going to continue financing your deposit withdrawals over a certain maximum amount per person and per month. We have got to assume that the other withdrawals are nothing other than capital flight and we are not going to use tax payers’ money to finance your capital flight. We are not going to tell you what to do but you are going to have to stop those withdrawals. And as regards financing the repayment of short-term bank loans, we won’t provide that either. Here you have to negotiate with your banks to extend the terms of those loans.

Finally, and most importantly, the financing of your current account deficit which presently runs around 10% of GDP. We don’t want to be bulls in the China shop by stopping our financing altogether but, at the same time, we can’t go on financing all your imports. Starting immediately and valid for one year, we will provide financing of the current account deficit up to 5% of GDP; thereafter we will reduce that limit to 3% of GDP. As regards the difference, you either have to reduce imports or increase exports and tourism, or a combination of the two. How you do that is up to you but you will have to do it”.

If EU/IMF/ECB had behaved that way from the start of the crisis, Greece today would be much further along the path of correcting/reforming her economy (for her own benefit!). Some lending institutions might have run into difficulties because of the above approach but that would have been their (and not Greece's) problem.